Executive Compensation: The Real RIsk

Although the correlation between executive pay and risk hasn’t been proven, there seems to be general agreement that a well-designed executive compensation package should allow for some risk while discouraging excessive risk-taking with an appropriate mix of long-term incentives and focus on performance based pay. 

However, there are a few problems with this:

•Focus on the Wrong Kind of Risk: When business analysts argue that executive compensation should encourage an appropriate level of risk-taking, they seem to be talking about bold acquisitions or moving into a new area of business to support long-term growth.  But there are other kinds of risk, for example, the risk to long-term company viability created by dramatic layoffs and other draconian cost cutting measures.  Executive compensation packages don’t typically guard against this kind of risk. 

•Flawed Definition of Pay for Performance: It seems reasonable to assert that executive pay should be based on performance, although my last post about tying rewards to creative endeavors discusses why this might not be such a great idea.  The problem is that when we talk about performance with respect to executives, for the most part we’re talking about share price.  Unfortunately, although share price is supposed to take long-term risks into account based on the efficient market hypothesis, we have seen how easy it is to inflate the perceived value of financial assets, at least for a while.

•Short-Term Incentives Disguised as Long-Term Incentives: According to the recent Workspan article ‘How Well Do You Understand the Relationship Between Pay and Risk?’, stock is generally the favored long-term incentive. The problem is that if you have a LOT of shares a .01 cent increase starts to look like real money in the short-term.  So, you can hold out for the long-term pay off, which will require luck, skill, and investment, or you can lay off a third of your key personnel and cancel the Christmas party and cash in now.  It takes a special sort of leader to take the high road when everyone else is cuttings costs and the rewards are far from assured.

•Executive Compensation is Set by Other Executives: There has been recent outcry that the government doesn’t have the expertise to control executive compensation, but do executives?  In his recent post ‘Why You Want Rich People to Set Your Pay,’ Bob Sutton noted that the higher the Board of Directors is compensated, the higher they will compensate the CEO on their watch.  This is possibly why we see so many outrageous examples of golden parachute agreements that provide former executives and their wives with lifetime tanning and poodle walking services.  (I made that up but it probably exists - see New Yorker article ‘The Pay Problem: What’s to be Done About CEO Compensation’ by David Owen for more sobering examples of golden parachute agreements.)

•No One is Watching the Watchers: Most company shareholders own a small number of shares, likely as part of a diversified portfolio managed by a fund manager and hidden in some sort of investment fund.  Although they may vote on Board elections, they have little actual power over the Board.  Theoretically, large fund managers can influence Board members but in practice they probably sell other lucrative fund management services such as 401K administration to the same company.  And although long-term company health is definitely a bonus, large investors make plenty of change on short-term windfall gains and the smaller investors who invest with them also benefit.  So, unless the entire system actually melts down, who’s complaining?

Despite claims that it’s difficult to understand the relationship between pay and risk, it's really not. Executive incentives tend to discourage long-term thinking and reward more short-term means of maximizing shareholder value. 

And that's pretty much what happens. 

Cartoon courtesy of Joshua Kennon.

Laura Schroeder is the Product Manager for Compensation Solutions at Workday, headquartered in Pleasanton, CA.  She has more than twelve years of experience designing, developing, implementing and evangelizing Human Capital Management (HCM) solutions in the US, Asia and Europe.   Her articles and interviews on HCM topics have been published in national and European trade journals.  She currently lives in Munich, Germany and enjoys reading, writing and spending time with friends and family.  

Comments

[Doug Sayed]

Well said Laura (and cool cartoon too)!

The current executive compensation schema is broken, and while the issues and potential solutions are complicated, I do know one thing: the government understands them far less than most of us compensation professionals do.

It's already getting a bit hot in the executive compensation kitchen, and boards and companies are starting to "get it" and make some positive changes (reducing ridiculous perks, excessive parachutes, etc.). It will likely take a few more years of increasing heat to squeeze more excesses out of the system, but it's starting to happen.

Also, see the comments made very recently by GE's CEO about executive pay. He's arguing for closing the gap between non-executive and executive compensation, and in being more reasonable and transparent in setting executive pay.

[Laura Schroeder]

Thank you, Doug. I laughed out loud when I ran across the cartoon. Good point about the government, especially now that it turns out (per Becky's post) they're as prone to inflate pay as the private sector. No lifetime poodle walking benefits yet but it sounds like they're learning fast.

[Paul Weatherhead]

Please don't give credence to the USA Today article about federal pay inflation. USA Today made errors that would make any compensation professional cringe! See my response to Becky's article.

[Laura Schroeder]

Thanks for commenting and clarifying, Paul.